Investment in wind power and pumped storage in a real options model

Promoting renewable energy has been a key ingredient in energy policy seeking to de-carbonize the energy mix and will continue to do so in the future given the European Union's high ambitions to further curb carbon emissions. A wide range of instruments has been suggested and implemented in various countries of the EU. A prominent policy promoting investment in renewable technologies is the use of feed-in tariffs, which has worked well at large scale in, e.g. Germany, but which has only been implemented in a very limited way in countries such as the UK. Being subject to environmental uncertainties, however, renewables cannot be seen in isolation: while renewables-based technologies such as wind and solar energy, for example, suffer from uncertain loads depending on environmental conditions, hydropower allows for the storage of water for release at peak prices, which can be treated as a premium (partially) offsetting higher upfront investment costs. In addition, electricity prices will respond to changes in electric capacity in the market, which is often neglected in standard investment models of the electricity sector. This paper contributes to the existing literature in two ways: it provides a review of a renewables-based technology in a specific policy context and provides additional insight by employing a real options approach to investigate the specific characteristics of renewables and their associated uncertainties in a stylized setting taking explicitly into account market effects of investment decisions. The prices of the model are determined endogenously by the supply of electricity in the market and by exogenous electricity price uncertainty. The inclusion of market effects allows us to capture the full impact of public incentives for companies to invest into wind power and hydro pumped storage installations. (C) 2012 Elsevier Ltd. All rights reserved.